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The basic idea is this: A rising U.S. interest rate environment relative to other countries is generally “positive for the dollar,” said Jonathan Petersen, senior market economist and foreign exchange expert at Capital Economics.
In other words, higher interest rates support a stronger U.S. dollar against foreign currencies, allowing Americans to buy more with their money abroad.
Petersen said the opposite trend — lower interest rates — tends to be “negative for the dollar.” A weaker dollar means Americans can buy less abroad.
Fed officials signaled in June that they plan to cut interest rates once in 2024 and four more times in 2025.
“At this point, we expect the dollar to come under further pressure next year,” Petersen said.
But that's not necessarily a foregone conclusion, and some financial experts believe the dollar's strength could persist.
“There have been a number of headlines calling for the demise of the U.S. dollar,” Richard Madigan, chief investment officer at JPMorgan Private Bank, wrote in a recent note. “I continue to believe that the U.S. dollar remains a one-eyed man in a blind country.”
The Federal Reserve began aggressively raising interest rates in March 2022 to curb high pandemic-era inflation. By July 2023, the central bank had raised interest rates to their highest level in 23 years.
This has accelerated the rise of the dollar.
The nominal broad U.S. dollar index is higher than any pre-pandemic point since the central bank began tracking the data in 2006. The index measures the dollar's appreciation against the currencies of the country's main trading partners, including the euro, Canadian dollar and Japanese yen.
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For example, in July 2022, the US dollar will reach parity with the euro for the first time in 20 years, with the exchange rate at 1:1. (The euro has since rebounded slightly.)
In early July, the US dollar hit a 38-year high against the yen.
A strong U.S. dollar “gives you discounts on everything you buy overseas,” Petersen said.
“In some ways it has never been cheaper to go to Japan,” he added.
The number of Americans visiting Japan in April hit a record high, according to the Japan Tourism Organization, and Benjamin Atwater, a public relations specialist at travel agency Inside Asia Tours, believes part of the reason is the economic incentives provided by a strong dollar.
In fact, he recently personally extended a business trip to Japan by a week and a half, citing favorable exchange rates as the main reason, instead of opting to travel to other Asian countries.
Atwater, a Denver resident who has always wanted to travel to Japan, said everything from meals to hotels, souvenirs and rental cars was “a great deal.”
“It's always been described as one of the most expensive places to be. [but] “For about $12, I had the best steak I've ever had,” he said.
In reality, the dynamics driving dollar fluctuations are more complicated than whether the Fed raises or lowers interest rates.
Economists say the difference between U.S. interest rates and those of other countries is what matters: Fed policy doesn't exist in a vacuum: other central banks are making interest rate choices at the same time.
The European Central Bank, for example, cut interest rates in June, while the Federal Reserve has kept them higher for longer than many forecasters had expected, widening the gap between U.S. and European interest rates and supporting the dollar.
“With the Fed keeping policy on hold and other central banks preparing to ease, the Bank of Japan appears to be sticking to the status quo,” JPMorgan's Madigan wrote.
Federal Reserve Chairman Jerome Powell speaks at a hearing of the Senate Committee on Banking, Housing and Urban Affairs on July 9, 2024.
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“If Japan wants to stabilize the yen, it needs to raise policy rates,” he added. “That's not likely to happen anytime soon. With the European Central Bank expected to cut rates ahead of the Federal Reserve, we also expect the current euro weakness to continue.”
Petersen said this is happening against the backdrop of a relatively strong U.S. economy, which is generally supporting a stronger dollar. At a high level, a strong economy generally means higher economic growth and inflation, making it more likely the Fed will keep interest rates at relatively high levels, he said.
And a strong economy typically motivates foreigners to park more money in the U.S., he said.
For example, investors generally get higher returns on their cash when interest rates are high. If an investor in Europe or Asia is earning perhaps a 1% or 2% return on holdings in a bank account, while a similar holding in the U.S. is earning a 5% return, he might move some of his money to the U.S., Petersen said.
Alternatively, if Europe's economic growth outlook is poor, investors may want to hold more of their portfolios in U.S. stocks rather than European ones, he said.
In these cases, foreigners buy dollar-denominated financial assets: They sell their own currencies and buy dollars, a process that ultimately leads to a stronger dollar, Petersen said.
He said exchange rates are “all driven by capital flows.”
These trends also hold true in emerging markets, but currency fluctuations can be more volatile than in developed countries due to factors such as political shocks and risks to commodity prices such as oil, he added.